Factor investing: limited overcrowding risk

03-07-2017 | インタビュー

A key concern often voiced by factor investing and smart beta sceptics is the possible risk of overcrowding. According to critics, the growing popularity of factors will inevitably lead to excessive bets and the disappearance of premiums. Such prophecies, however, seem to be based on misguided intuition rather than serious empirical research. Rigorous analysis suggests overcrowding fears are clearly overdone, says David Blitz, Robeco’s Head of Quant Equity Research.

David

Blitz

Head of Quant Research

Do you think overcrowding poses a serious threat to factor premiums? “In a nutshell, I think such concerns are exaggerated. Allocation to factors and factor-based strategies has been done for decades, but the premiums provided by these factors have not disappeared. Moreover, if there is a rational economic explanation for eligible factors, as I think there is, there is no reason to believe such premiums will disappear even if many investors are aware of their existence. The arguments that are used to justify overcrowding concerns are typically not evidence-based, but tend to be gut reactions. For instance, the rising valuation of low-volatility stocks is cited as evidence that too much money has been poured into these strategies, while a long-term historical perspective shows that current valuations are not unusual at all. For instance, low-volatility stocks were also more expensive than the market in the 1940s and 50s, when low-volatility investing was still a completely unknown concept.“

Could the rapid expansion of smart beta ETFs change that? “In theory it could. But let’s take a look at the evidence. In a recent academic paper* , I analyzed factor exposures of a broad sample of US equity ETFs, by regressing their returns on the returns of various well-known factors, based on data recorded in late 2015. I found that many funds indeed offer a large positive exposure to factors, such as size, value, momentum and low volatility. As such, they can be considered suitable instruments for investors seeking to systematically harvest these premiums, except perhaps for the momentum premium. At the same time, however, I also found that many other US equity ETFs had a similarly large degree of negative exposure towards the very same factors. On balance, the exposures towards the size, value, momentum and low volatility factors turned out to be very close to zero. These findings clearly go against the idea that factor premiums are rapidly being arbitraged away by ETF investors. They also contradict the related concern that factor strategies could be turning into overcrowded trades.”

Still, impressive growth in assets under management targeting specific factors looks like a warning sign… “Yes… and no. The increased popularity of low-volatility strategies is a good illustration of this. Low volatility was one of the first market anomalies to be identified. At first glance, investors looking only at the billions of dollars invested in ETFs who are specifically targeting this anomaly may rightfully be concerned about possible overcrowding. However, upon closer examination, the funds in question are found only to represent a small fraction of the total ETF market. Moreover, at the other end of the spectrum, you find a similar number of ETFs which provide exactly the opposite factor exposure, with a significant bias towards high-volatility stocks. These ETFs are typically sector-focused funds. They are obviously not labelled ‘high-volatility funds’ but they do effectively neutralize the exposure of the low-volatility ETFs. In other words, based on ETF data, one might just as well argue that high-volatility stocks are overcrowded, instead of low-volatility stocks. Or that both are equally overcrowded, in which case the concept of overcrowding also loses its meaning.”

What if some opportunistic investors start betting massively on one specific premium? “That’s a possibility, but again, despite the fact that some factors have been identified for more than 40 years in the academic literature and are now very well-known in the investment industry, we do not see it actually happening. To illustrate this, in another recent paper** , I analyzed the exposure of hedge funds towards low volatility, using indices from two leading providers, Hedge Fund Research and Credit Suisse, over the ten-year period from January 2006 to December 2015. Hedge funds are by nature both opportunistic and flexible. Therefore, one would expect them to actively bet on low-volatility stocks. But, as surprising as it may seem, this is not the case. On the contrary, the analysis showed very clearly that, despite their flexible approach to investing, these funds tend to bet strongly against the low-volatility anomaly. This is another indication that the low-volatility trade is still far from being overcrowded.”

Limits to arbitrage may not be the main reason

OK. But these findings also seem to refute one of the most frequently mentioned reasons that explain the existence factor premiums: limits to arbitrage. “That is true. Investment restrictions faced by investors, such as constraints on leverage, short-selling and being evaluated against a benchmark, are often cited among the key reasons for the existence of factor premiums. But my analysis of hedge funds returns suggests this may not be the main reason after all, since these constraints do not really apply to this category of investors. Other explanatory factors that have been proposed in the academic literature, such as portfolio managers being willing to overpay for high-volatility stocks in order to maximize the expected value of their option-like compensation schemes, may be more important.”